Working paper, August 1999.
Abstract: This paper provides a new framework for evaluating the welfare effects of tax reforms. It is shown that tax reforms are welfare improving if and only if they satisfy the following intuitive property: on average, consumer prices fall for commodities with high marginal excess burdens. The rule is then applied to analyze a shift from indirect to direct taxation. The welfare impact of such reforms can be decomposed into two effects: (i)~the increase in welfare associated with substitution among taxed commodities, and (ii)~the loss in welfare associated with substitution between commodities and leisure. On balance, direct tax reforms are desirable when inter-commodity substitution effects are large relative to commodity--leisure substitution effects. The analysis allows us to reconcile the apparently conflicting results of the tax reform and optimal taxation literatures.